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What do countries need to do in order to create a policy framework that is conducive to foreign direct investment? And when FDI does begin to flow in, how can they ensure that it supports local economic development, and not just the bottom lines of large multinational corporations? For leaders in emerging economies such as Vietnam, Indonesia, and India, getting these questions right will go a long way toward determining what type of an economic future they’ll be able to deliver for their citizens.

FDI-in-China
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China’s approach toward, and experience with FDI, provides us with an immensely valuable “real world” test case from which we can draw a wide range of lessons.

In a forthcoming book on FDI in China, “Developing China: The Remarkable Impact of Foreign Direct Investment”, Professor Michael Enright meticulously describes the historical evolution of China’s policy approach toward attracting and managing FDI since it began to open its economy in the 1980s. If policies are to be judged by the results they produced, then China’s FDI policies would have to be regarded as an overwhelming success, as Professor Enright’s groundbreaking economic impact analysis reveals just how central FDI has been to China’s economic ascent.

At the same time however, Enright’s work can be read as somewhat of a cautionary tale, as China’s more recent treatment of foreign companies has led some to wonder if FDI is now becoming less welcome in China. Given the contributions FDI has made – and continues to make – to China’s economic success, such a change in course would be unfortunate indeed.

The story of FDI and China’s economic transformation begins in the 1980s, when China embarked on a gradual reform and opening-up process designed to close the massive developmental gap between China and the West. In order to modernize industrial sectors that were downright antiquated by western standards, China’s leaders realized that the door would have to be opened to foreign companies who could provide technology, know-how, and experience in foreign markets.

Opening the door to foreign companies was seen however as a risky proposition with significant potential downside. China’s leaders were, in a sense, trying to capture lightning in a bottle – to unleash an unprecedented FDI-driven modernization of their economy, without ceding control to foreign companies, or precipitating severe social dislocations.

The key was to open the door gradually. The reform process unfolded in an incremental, step-by-step manner, and Special Economic Zones (SEZs) were used as laboratories to test and calibrate reforms before implementing them on a wider scale. FDI was to be permitted, and in some cases even encouraged, but always under very controlled circumstances.

Without attempting to comprehensively trace the history of these policies, one or two are worth highlighting. China’s sector based investment policies are especially noteworthy, as they allowed China to essentially channel FDI into those specific sectors deemed to have the most strategic value. This targeted, almost surgical, approach to permitting FDI allowed Chinese officials to maintain a high degree of control, while ensuring that FDI was supporting the country’s overall economic development plans and objectives.

This was accomplished by the establishment of the so-called “catalogue” (first issued in 1995, but amended many times since then) which essentially classified business activities for receiving FDI into “encouraged”, “permitted”, “restricted”, and “prohibited” categories. As Professor Enright explains, “in encouraged industries, wholly foreign-owned enterprises, equity joint ventures, and cooperative joint ventures are permitted. Industries not listed, unless forbidden by other laws and regulations, are ‘permitted’ and generally open to FDI via the same vehicles. In ‘restricted’ industries, FDI is subject to strict examination and approval on a case-by-case basis, with potential limitations on company vehicles and foreign control. In ‘prohibited’ industries, FDI is not permitted at all. There are also specific catalogues for specific sectors and for some geographic regions.”

In recent years, some observers claim to have detected a shift in China’s policy approach to FDI, charging that, while more sectors of the economy have been opened to foreign investors, the regulatory regime, and in particular the Anti Monopoly Law of 2007, is being used to unfairly target and harass foreign companies in order to tilt the competitive playing field toward domestic companies.

According to this viewpoint, now that China has “gotten what it wants” from FDI (principally the technology and know-how to empower the development of world-class domestic companies), it will gradually begin to squeeze foreign companies out of China. Chinese officials have steadfastly denied these allegations, claiming that all laws and regulations have been applied in a fair and non-discriminatory manner, and pointing out that, for instance, far more Chinese companies have been targeted under the Anti Monopoly Law than foreign.

For now, it’s safe to say that this is an issue that will bear close watching. One should expect to see China’s policy approach toward FDI to continue to evolve in order to meet China’s changing developmental needs, realities and objectives – just as it has for the past three decades.

One thing is clear though. The transformative potential of FDI is immense. But the results it brings are not preordained to be either positive or negative, so the policy framework that surrounds it is crucial. The terms, conditions and stipulations under which FDI is permitted and provided all shape the results and outcomes. Getting policies right and building mutually beneficial partnerships between FDI providers and host countries is therefore essential.

Policy makers and business leaders alike would do well to closely examine China’s experience with FDI. This is not to suggest that China’s approach has been perfect. Nor would it be appropriate to suggest that any country should seek to replicate China’s strategies. But the sheer volume of FDI absorbed by China, and the epic economic transformation it produced, means that China is an indispensable reference point for any country charting its path forward with FDI.

AuthorStephen Olson – Research Fellow at the Hinrich Foundation.
Follow Stephen Olson on Twitter @StephenOlsonHF